Broker Check

Volatility is back, but is inflation the biggest risk?

| May 23, 2021
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Does having a diversified portfolio ever make you feel like you're missing all of the fun? 

Admittedly, speculative assets can hold unmistakable allure during robust market periods.  Whether cryptocurrencies in 2020 or “dot com” stocks in 2000, investors might ask, “Why didn’t my advisor diversify my portfolio like that?” 

There is always a hotter stock, industry or country to invest in. But what's hot seldom stays that way.  And the fall from grace can be rapid and painful, as many investors are seeing this year.

In Praise of Boring Assets

We're not going to apologize for being fans of boring investments.  From a purely financial perspective, our view of investing boils down to three questions:

  • What is the simple math (expectations of income + appreciation = total return)? 
  • Is this investment different from other portfolio holdings (does it diversify risk)?
  • What is the financial underpinning?   This is the logic that distinguishes an investment and mere speculation, and as a fiduciary, it is a requirement for us.

Stable income earners like partnerships in solar energy and real estate, or diversified global equity funds, or portfolios of dividend growers -- these long-term wealth builders all seem dull until markets become volatile. And volatility has indeed returned, with a vicious tug-of-war occurring between richly priced growth stocks and the “value” shares that have underperformed since 2008.

Some past winners have lost half their value from recent highs.  (Ever-volatile cryptos have lost half, or more, from their peaks.) Worries over inflation have growth stock investors undoubtedly spooked.  

What about inflation?  (There are worse risks.)

Our readings suggest that elevated inflation should be largely temporary, a product of imbalances from a sharp recession and rapid reopening. But with so much stimulus, the economy could run hot.  We wouldn't at all be surprised to see the Fed start "tapering" down their operations in the bond markets.

In the short term, market leadership has changed, interest rates have risen, and investors have grown skittish.  There's nothing surprising about investors wishing to take money off the table after the market rebound over the past year.  And those late to the party are suddenly looking at losses and may be quick to sell.

More worrisome than a little volatility, however, is that today’s investors may be taking more risk than they know, having allowed portfolios to drift to higher equity allocations over time.  Many have added speculative positions.  It is also well documented that investors’ “home bias” (more US) has continued to grow. 

Another interesting element of risk is that portfolio concentrations might possibly be higher than any time in recent memory. Did you know that five large cap tech stocks now account for 20% of the S&P500?  It's likely that these stocks comprise a significant part of many investor portfolios.

So, risks could be lurking in full view, but monitoring such risk is complex.  Boardwalk Capital employs a "Risk Number" philosophy to make sure that portfolio risk stays in line with client tolerances.  We profile each client and Stress Test their portfolio performance under hostile conditions (i.e., simulating the 2008 financial crisis.)  This can bring into sharp resolution (in real dollars) the amount of risk that an investor is taking. 

Visit www.boardwalkcm.com to stress test your portfolio, or just give us a call.

Eyes on the prize

Given all this, volatility can be helpful (yes, helpful) if it reminds us to keep our eyes on theactual prize.  It can help us remember to play the long game of building wealth by compounding attractive long- term returns across a variety of less-correlated assets (whether solar energy, real estate, or even unique credit strategies or private equity).

The challenge, of course, is in our basic human nature. Investors look at their portfolios and may not see these different risks.  (The Stress Test DOES see them.)  Instead, they are more likely to get frustrated that some of their alternative investments can take years to get fully invested...

Diversification requires patience when we're in a robust market environment — especially when the sequence of returns for a particular investment is weighted more to the future.  On the other hand, if such investments can generate equity-like returns without equity market risk, then the long-term investor is the winner with a smoother ride and the returns that they need. 

Human nature is unlikely to change, but with the mindset of a business owner, we can see the compounding at work across a diverse portfolio of public and private "businesses”. 

In other words, we can be in tune with the actual workings of our portfolio. If volatility is what eventually gets us to have this mature look at our investments, then that not-so-gentle reminder is valuable indeed.

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